Jensen's Portfolio Performance Measure - Meaning, Advantages and Limitations

Portfolio Performance Evaluation
Unit 4 SAPM Notes 
Jensen's Portfolio Performance Measure

Jenson Model

Jensen's model proposes another risk adjusted performance measure. This measure was developed by Michael Jensen and is sometimes referred to as the Differential Return Method. This measure involves evaluation of the returns that the fund has generated vs. the returns actually expected out of the fund given the level of its systematic risk. The surplus between the two returns is called Alpha, which measures the performance of a fund compared with the actual returns over the period. Required return of a fund at a given level of risk (b) can be calculated as:

Rt – R = a + b (Rm – R)

Where, Rt = Portfolio Return

R = Risk less return

a = Intercept the graph that measures the forecasting ability of the portfolio manager.

b = Beta coefficient, a measure of systematic risk

Rm = Return of the market portfolio

Thus, Jensen’s equation involves two steps:

(i) First he calculates what the return of a given portfolio should be on the basis of b, Rm and R.

(ii) He compares the actual realised return of the portfolio with the calculated or predicted return. Greater the excess of realised return over the calculated return, better is the performance of the portfolio.

Limitation of this model is that it considers only systematic risk not the entire risk associated with the fund and an ordinary investor can not mitigate unsystematic risk, as his knowledge of market is primitive.

Graphic representation of Jensen’s model is a given in the following figure:

The figure shows three lines showing negative, neutral and positive values. The negative line shows that the management of the performed portfolio is inferior. The positive line shows that superior quality of management of funds. The neutral value shows that the performance of the fund is similar to the performance of the market portfolio.

A comparison between the three models shows that the intercept of the line is Sharpe and Treynor models is always at the origin, where as Jensen’s model it may be at the origin (a = 0), above the origin (a > 0) and even be below the origin indicating a negative value (a < 0). The risk adjusted measures have been criticized for using a market surrogate instead of the true market portfolio. These measures have been unable to statistically distinguish luck or change from skill except over very long period of time. Moreover, these models rely heavily on the validity of CAPM. If in estimating the measures the analyst assumes the wrong from of the CAPM in the market place, he will get based measure of performance, usually in favour of low risk portfolios.

Advantages of Jensen's Portfolio Performance Measure

a) This model is very easy to interpret.

b) It helps to measure how much of the portfolio's rate of return is attributable to deliver above-average returns, adjusted for market risk. The higher the ratio, the better the risk adjusted returns.

c) Because it is estimated from a regression equation, it is possible to make statements about the statistical significance of the manager’s skill level.

d) It is flexible enough to allow for alternative models of risk and expected return than the CAPM.

Disadvantages of Jensen's Portfolio Performance Measure

a) Weakness of Treynor’s ratio is that it requires an estimate of beta, which can differ a lot depending on the source which in turn can lead to mis-measurement of risk adjusted return. Many investors accomplish that a beta cannot give a clear picture of risk involved with the investment.

b) It does not consider the advantage of a diversified portfolio.

c) Jensen’s alpha doesn’t take the portfolio’s volatility and takes into account, only the expected return.

d) It will miss out on characteristics such as returns kurtosis and skewness, which are of great importance in determining whether you’ll go broke before you realize profits.